Shotgun Wedding: Fiscal and Monetary Policy∗
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Shotgun Wedding: Fiscal and Monetary Policy∗ Marco Bassettoy and Thomas J. Sargentz April 7, 2020 Abstract This paper describes interactions between monetary and fiscal policies that affect equi- librium price levels and interest rates by critically surveying theories about (a) optimal anticipated inflation, (b) optimal unanticipated inflation, and (c) conditions that secure a \nominal anchor" in the sense of a unique price level path. We contrast incomplete the- ories whose inputs are budget-feasible sequences of government issued bonds and money with complete theories whose inputs are bond-money strategies described as sequences of functions that map time t histories into time t government actions. We cite historical episodes that confirm the theoretical insight that lines of authority between a Treasury and a Central Bank can be ambiguous, obscure, and fragile. ∗We thank John H. Cochrane and a referee for helpful comments. The views expressed in this paper are those of the authors and not necessarily those of the Federal Reserve Bank of Minneapolis or the Federal Reserve System. When citing this paper, please use the following: Bassetto, Marco, Sargent, Thomas J. 2019. Shotgun Wedding: Fiscal and Monetary Policy. Annual Review of Economics: Submitted. https://doi.org/10.1146/ annurev-economics-091319-050022 yFederal Reserve Bank of Minneapolis zNew York University and Hoover Institution 1 The best way to defend the independence of a central bank is never to exercise it. Anonymous Federal Reserve official 1 Introduction A government's budget forces monetary and fiscal policies to be either coordinated or consol- idated. From the point of view of sequences of government IOUs called bonds and money, institutional arrangements that delegate decisions about bonds and money to people who work in different agencies are details. Central bank independence is a convention or a fiction. Episodes from 19th and early 20th century US monetary-fiscal history illustrate our theme that a government budget doesn't sharply separate monetary from fiscal policy. When the United States had no central bank before 1914, Secretary of Treasury Leslie M. Shaw leaned against the wind by depositing federal funds in temporarily distressed commercial banks and afterwards returning them to the Independent Treasury vaults where, according to the Independent Treasury Act of 1846, they belonged.1 Shaw (Treasury 1906, page 49), wrote that \No central bank or government bank in the world can so readily influence financial conditions throughout the world as can the Secretary under the authority with which he is now clothed."2 Shaw's landmark 1906 Treasury report culminated more than 50 years of extralegal actions by Secretaries of Treasury and compliant Congresses that by 1906 had subverted 1830s and 1840s Jacksonian intentions to separate US fiscal and monetary activities from all banks, public and private.3 The Independent Treasury Act that governed US cash-management practices from 1846 until the founding of the Federal Reserve in 1914 banned the Secretary of Treasury from depositing federal funds in banks, a rule that had eroded so much by 1906 that Secretary Shaw could write 1See \Central-Banking Activities of the Treasury" in Friedman and Schwartz (1963, ch. 4). 2In the same report, Shaw asked Congress for even more power: \::: $100,000,000 to be deposited with banks or withdrawn as he might deem expedient, ::: [and] authority over the reserves of the several banks with power to contract the national-bank circulation at pleasure :::." 3See Hofstadter (1948, ch. 3) and \The Jacksonian Movement and the Bank War" in Rothbard (2002). 2 openly about ignoring it. Prospective profits from issuing paper bank notes fueled that erosion process. After Andrew Jackson's Democrats in the 1830s and 1840s had forced the Federal gov- ernment to forego them, state governments quickly moved to gather some of those profits by chartering state banks that issued low denomination circulating notes backed by state bonds as collateral. States issued those charters on the condition that the banks would share profits with the state governments. During the Civil War, the US government nationalized those profit sharing arrangements by imposing a tax that put state banks out of the note issuing business and establishing a National Banking system whose member banks were authorized to issue Na- tional Bank Notes collateralized by a list of Federal bonds. With that nationalization and other measures, Congress abandoned the Jacksonian hands-off, hard-money policy and put Congress in day-today charge of running U.S. monetary policy. In 1862, Congress issued an inconvertible currency called the greenback that it made legal tender for almost all debts public and private and whose value soon dropped to 40 or 50 cents in terms of the gold dollar that continued to be used for international trade and customs duties. That set off years of Congressional debates about how many greenbacks Congress should issue or withdraw and whether Congress should service interest-bearing Federal bonds with gold dollars or depreciated greenbacks. Congress resolved that dispute, but only temporarily as it eventually turned out, when on January 1, 1879 it made greenbacks convertible into gold dollars one for one. From the Civil War until the founding of the Federal Reserve in 1914, monetary policy gave headaches and heartaches to U.S. Congresses. Congresses authorized various paper monies { greenbacks, silver certificates, National Bank Notes { and, against the background of a declining price level from 1865 to 1896, confronted political pressures to issue more money and to broaden the collateral behind the National Bank Notes that had been confined to a list of Federal bonds. For example, in 1889 the Farmer's Alliance called for issuing low denomination Treasury notes in exchange for collateral in the form of farmers' crops to be stored in government warehouses to be called subtreasuries.4 Silver producers and inflation proponents advocated coining silver or issuing federal notes collateralized by silver at an exchange rate that, relative to market prices, 4See White (2017, p.830) and Malin (1944). 3 overvalued silver by a factor of two or three. Secretary Shaw's 1906 report lamented that his ability to conduct open market operations was limited by the accumulated cash (i.e., greenbacks, National Bank notes, silver certificates, gold coins) that he held in independent treasury vaults. To relax that constraint, during financial crises clearing houses issued collateralized certificates that temporarily served as cash substitutes. To expand what counted as cash, the 1902 \Fowler Bill" and other unsuccessful proposals would have authorized banks to issue notes backed by rail- road bonds, municipal securities, and other assets. The force behind those proposals eventually led Congress to pass the Aldrich-Vreeland Act in 1908 that, among other things, authorized the Comptroller of Currency to issue emergency currency collateralized by various types of private securities to coalitions of banks organized in national currency associations. Congress delegated these and other monetary management headaches when in December 1913 it passed the Federal Reserve Act.5 In this paper we mostly ignore institutional details and instead focus on the arithmetic that binds monetary to fiscal policy.6 Only when we discuss theories of \nominal anchors" for a price level sequence in worlds with only fiat paper money shall we be forced to study how a polity assigns budgets and actions to separate decision makers called a treasury and a central bank. Section 2 uses a baseline model to describe how a gold standard secures a nominal anchor, then tells how the addition of a paper money can improve outcomes but leaves an exchange rate between paper and gold indeterminate. That indeterminacy is our first encounter with difficulties in securing a unique nominal anchor for a paper currency. Section 3 extends our baseline model to include an intertemporal consolidated government budget within which we can study theories of an optimal quantity of money under flexible prices. Here we study normative theories of both anticipated and unanticipated inflation. Section 4 uses irrelevance theorems for open market operations to frame difficulties in distinguishing between monetary and fiscal 5To divorce monetary from fiscal policy, the Federal Reserve Act constrained the Fed to issue notes and reserves backed only by \real bills" { evidences of low-risk short term commercial debts. World War I fiscal exigencies soon led Congress to look the other way when the Fed's \borrow and buy" for Liberty Bonds evaded the real bills restriction. 6We also limit our discussion of the closely related fragile line that separates monetary from credit policies. 4 policies when considering \quantitative easing" and a debate on the relevance of the government budget constraint when the interest rate is smaller than the growth rate of the economy. While sections 2, 3, and 4 naturally cast monetary-fiscal policies in terms of sequences of settings of monetary and fiscal policy variables, e.g., government taxes and expenditures and bonds and money supplies, we must proceed differently when we study a “fiscal theory of the price level" in section 5 in terms of government strategies (i.e., sequences of functions that map time t histories into time t actions) that are sufficient to deliver a unique price level path and thereby secure a nominal anchor. Section 6 extends our discussion of fiscal theories of nominal anchors